EXECUTIVE SUMMARY



EXECUTIVE SUMMARY

Submitted

November 15, 1999

To:

Advisory Commission on Electronic Commerce

3401 North Fairfax Drive

Arlington, VA 22201-4498

By:

Submitted by:

Norris Nordvold

Intergovernmental Programs Director

City of Phoenix

200 West Washington, 12th Floor

Phoenix, AZ 85003

602-256-4257

nnordvold@ci.phoenix.az.us

The advent of the Internet as a marketing and sales distribution media for business presents a real threat to local sales tax revenues. Within five years that impact could reasonably be $9 to $11 million less in revenue annually to the City of Phoenix in retail sales taxes due to consumer purchases made via the Internet. Local sales tax revenue funds basic community services such as Fire, Police, parks and libraries.

The following summarizes the most likely scenario estimate of the impact of Internet-based sales activity on sales tax revenues. Included are the General and Proposition 301 funds portions of the local sales tax as well as the city’s portion of the state retail sales tax.

Estimated Revenue Losses to Internet-Based Retail Sales

in millions of dollars

|Fiscal Year |General Fund |Prop 301 Est. |State Sales Tax |Total Estimated Lost |

| |Est. | |Est. |Revenue |

| | | | |(in millions$) |

|1999-2000 |0.8 |0.0 |0.1 |0.9 |

|2000-2001 |1.2 |0.1 |0.1 |1.4 |

|2001-2002 |2.4 |0.1 |0.2 |2.7 |

|2002-2003 |4.3 |0.2 |0.4 |4.9 |

|2003-2004 |7.8 |0.4 |0.7 |8.9 |

The above analysis does not include the impact of the increased use by businesses to purchase both raw materials and consumables.

If the Commission is to recommend to Congress that the Internet remain a tax-free zone and even the catalyst for lessening sales tax across all mediums, then the Commission should also provide national leadership in devising alternative revenue sources that preserve basic municipal and county services.

We ask that you work with local government leaders on devising a long-term strategy that will best serve our citizens who want to purchase goods and services at a fair price and also have a two minute response to a 911 call.

Thank you for the opportunity to share our concerns.

PHOENIX BUDGET AND RESEARCH DEPARTMENT REPORT

ESTIMATED IMPACT OF INTERNET TRANSACTIONS ON SALES TAX REVENUE

The advent of the Internet as a marketing and sales distribution system for businesses, or ‘ecommerce’, has drawn the attention of state and local governments. Of primary concern to state and local governments is the lost sales tax revenue on purchases such as retail sales made via the Internet. A secondary emphasis is on the actual taxation of Internet services such as the access fees. So much attention has been drawn to the topic that in October 1998, President Clinton signed the Internet Freedom Act. That act established a three-year moratorium on the introduction of new taxes on Internet service fees and provides for study of taxation of electronic commerce at the federal level. As part of the City’s effort to participate in discussions on this topic, background on the City’s current taxation structure and an estimate of the direct impact on the City’s sales tax revenue is required.

KEY RESEARCH FINDINGS

Phenomenal growth rates have been achieved and are forecasted for Internet sales activity. Forrester Research Inc. is a leader in research and forecasting in the area of Internet or ‘ecommerce’ activity and is the source of many of the assumptions used in this report. Because use taxes exist and are primarily targeted toward business-to-business transactions, much of the research on internet activity is separated into two classifications: business-to-business and business-to-consumer or retail activity. The theory is that business-to-business transactions are clearly covered in use tax provisions or are sales for resale that are exempt from sales taxation and therefore should be separated from the retail sale to end users or consumers for studies of taxation.

CURRENT TAXABILITY OF INTERNET-BASED TRANSACTIONS

As it does for phone or catalog sales, Phoenix has nexus to tax some transactions made via the Internet. If the vendor has a physical presence in Phoenix and a sale of a taxable item is made to a Phoenix resident; nexus exists for Phoenix to levy its sales tax. As an example, if a Phoenix resident purchased for use in their home an item from a large retailer such as JC Penney via the Internet, catalog or by walking into a Phoenix store, the City has nexus to tax any of those sales. The same could not be said for a catalog or internet-based sale to a Phoenix resident by a retailer with no physical presence here.

Phoenix also has a use tax provision. A use tax is applicable when items are purchased for use or consumption within the city where no equivalent local sales tax has been paid on the purchase. The purchaser or consumer pays the use tax and typically results from purchases made from out-of-state vendors. Use taxes provide some protection for local vendors against loosing business simply because no sales taxes would be applied to a sale by an out-of-state vendor. In practice, many businesses pay use taxes, but very few individuals do.

An Ernst & Young study and others provide information to evaluate the potential taxable nature of the business-to-consumer activity. The Ernst and Young estimates are that 37% of sales made via the Internet to consumers are taxable in traditional sales tax models. An analysis of the items excluded (e.g., financial services, food, travel) is consistent with the City’s tax code. However, some excluded items such as interactive games or on-line newspaper subscriptions could be considered taxable. Because there is not sufficient detail available to analyze the taxable and non-taxable elements of Internet-based sales, this analysis will apply the concept that if in 1998 Internet sales represented 0.3% of total retail sales, then they represented 0.3% of taxable retail sales.

Ernst & Young also reports information on the taxed status of Internet sales. They do this by breaking down the 37% that are taxable per their analysis into three components: 4% of the total are taxed, 20% are a substitute of Internet for catalog sales, and 13% are not taxed. In a separate analysis done in late 1998, Budget and Research conclude that approximately 35% of catalog sales include Phoenix tax and 40% include State of Arizona taxes. These concepts will be applied in this analysis to account for taxes already paid on Internet-based transactions.

ESTIMATE OF LOST RETAIL SALES TAX REVENUE

Attachment A provides an analysis using the most current five year forecasts for local sales taxes and the key assumptions taken from the above research findings to develop estimates of local tax revenues lost due to untaxed sales to consumers via the Internet. The analysis assumes that only the retail sales category of the local sales tax is significantly impacted by Internet-based transactions.

ATTACHMENT A

_____________________________________________________________________________________

Raw materials are sales for resale and are not subject to sales or use taxes, but the purchase of most consumables such as office supplies are. Overall, businesses are more likely to pay use taxes than are consumers. However, it is likely that the compliance levels for use tax reporting are lower than for sales tax. For the purpose of this analysis, there is not sufficient information on business-to-business transactions conducted via the Internet or use tax compliance rates to estimate the potential lost tax in this shift from sales to use taxable transactions. To provide some measure, use taxes have amounted to 7 to 7.4% of retail sales taxes in the last three years. Using 7% of the estimated lost retail sales tax as the basis to estimate lost use taxes, would equate to an additional $500,000 to $600,000 loss in 2003-04.

Finally, the above is an estimate based on most likely or expected outcomes. There is a broad range of potential variability in this forecast. For example, Internet transaction growth could advance more quickly than projected causing the impacts to grow more quickly and to a greater degree. If the annual growth rate in consumer activity were at an 80% per year rate rather than 70%, the impact on this analysis would be an estimated loss in 2003-04 of $11 million or $2.1 million and almost 25% greater. At a 100% annual growth rate, the estimated loss would be in excess of $20 million in 2003-04. The mix of the type of transactions purchased via the Internet could also shift toward or away from taxable transactions. For example, some of the growth is expected to be from larger vendors adding Internet to their mix of marketing tools (e.g. JC Penney and Sears are recent or planned adds to the Internet market that would be taxable in the Phoenix tax structure).

Also, not measured in this analysis is the potential impact on the local businesses and economy as resources are shifted to businesses outside. Such a loss would go well beyond that of direct sales taxes foregone.

The research suggests that the business-to-business element is the largest portion of the current ‘ecommerce’. In addition, much of the business-to-consumer activity is currently in areas not typically subject to sales and use taxes. These include travel and financial services primarily. However, it is clear that more and more consumers are gaining access to and confidence in Internet-based transactions. Here are some Forrester statistics on the size and projected growth ‘ecommerce’ sales activity:

| | 1998 Estimate 2003 Forecast |

| Business-to-business hard goods trade | $ 43 billion $ 1,300 billion |

| Average annual growth = 99% | |

| | |

| Business-to-consumer/retail sales | $ 7.8 billion $ 108 billion |

| % of total consumer sales | 0.3% 6% |

Based on the Forrester forecasts, the average annual growth rate for consumer or retail sales is 70%. Other sources cite growth rates at 80 to 100%. The Forrester statistics and forecasts are consistent with others that suggest an approximate 80/20 split of Internet sales activity between business-to-business and consumer sales. This analysis will use the 70% growth rate forecast as the most likely scenario.

An analysis of categories of revenue generated in business-to-business transactions in a Forrester report reveals that in 1998 approximately 50% are transaction types subject to sales or use tax and that percentage declines to near 40% in the 2003 forecast.

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